Banking scope and financial innovation

We explore the implications of financial system design for financialinnovation. We begin with assumptions about the investment opportunitiesof firms, their observable attributes, and the roles of commercialbanks, investment banks, and the financial market. We examinethe borrower's choice between bank and financial market funding,the commercial bank's choice of monitoring capacity, and theinvestment bank's choice of whether to invest in financial innovation.Our main result is that financial innovation in a universalbanking system is stochastically lower than innovation in afinancial system in which commercial and investment banks arefunctionally separated.     

Financial system architecture

This article builds a theory of financial system architecture.We ask: what is a financial market, what is a bank, and whatdetermines the economic role of each? Starting with basic assumptionsabout primitives-the types of agents and the nature of informationalasymmetries-we provide a theory that explains which agents coalesceto form banks and which trade in the capital market. It is shownthat borrowers of higher observable qualities access the financialmarket. Moreover, a financial system in its infancy will bebank-dominated, and increased financial market sophisticationdiminishes bank lending.